Broken Banks, Durable Delusions

Some 829 commercial banks are at risk of failure, according to the Federal Deposit Insurance Corp. This year 118 banks already failed and were taken over by the FDIC. At this rate, more banks will fail in 2010 than in 2009. If bank regulators were a commercial bank, they too would have gone bust. But being government entities, they prosper as the industry they oversee declines.

Investment banks dominated the public discussion in the run-up to the gigantic new financial regulation law. Regulation advocates argued that investment banks took excessive risk and needed to be more heavily regulated. Commercial banks were not the focus of the discussion—-because they have been heavily regulated since the early 20th century.

In fact, commercial banks are about as regulated as possible for private enterprises. Further regulation would turn them into an arm of the government—along the lines of mortgage financer Fannie Mae, currently a black hole that sucks taxpayer money.

Commercial banking regulation has not prevented cyclical waves of bank failures. The previous one was the savings and loans crisis of the 1980s, when around one in every two savings and loan associations went bankrupt .

The reason banks fail is the same as it has always been since they’ve existed: they make bad loans, often in market conditions that encourage optimism. People have a penchant to be overly hopeful when markets go up. As a feature of human nature, this applies to everybody—-lenders, borrowers and regulators.

Having ever-larger contingents of regulators and bureaucratic procedures has not changed the basic cyclical pattern. Memories of past banking crises fade, the older generation retires and it looks like there’s a whole new world where the old strictures no longer apply—-see Jerry O’Driscoll’s review of This Time is Different by Reinhart and Rogoff. It looks that way not just to bankers but also to their regulators.

In the recent case, the real estate bubble, including the boom in commercial property, encouraged bad loans. The main regulator of the banking system, the Federal Reserve, far from trying to restrain banks, supplied the monetary fuel for the over-expansion of credit and the associated property bubble.

Nevertheless, the new law gives the Fed greater authority over investment banks on the ground that it will, or at least could or might, prevent future bank crises. Why did the Fed not do this with regard to commercial banks, for which it did not need additional authority? If the usual suspects – the Bush administration, Alan Greenspan – refused to take action, why didn’t Timothy Geithner, long-time head of the New York Federal Reserve Bank, say something?

He warned against the expansion of derivatives, but that was not an issue for small commercial banks. You can fail just as badly without touching any exotic derivative. There is no evidence that he was concerned about the twin credit and property bubbles or about the thousands of banks busily financing real estate by making old-fashioned loans.

It hard to see how the new regulatory powers Mr. Geithner defended as Obama’s Treasury secretary would have made any difference for the smaller banks in the boom/bust cycle. The Fed should obviously refrain from feeding bubbles, but for that it makes more sense to limit – not expand – its discretion.

None of this supports the belief that financial ills can be cured by extending government oversight. Yet that delusion retains its hold on many people’s minds even as packs of highly regulated banks go broke week after week.

In the US there have always been, and apparently there still are a huge number of small banks which die in droves at every downturn.

In the XIX century this was due to states’ laws outlawing bank branching. The bigger Canadian banks are far less prone to systemic crises, and probably most of the difference between Scotch and English banks were due to the six-person rule limiting joint-stock banks.

I know nothing about modern day regulations. What about now? Why are there so many unstable lilliputian banks still in operation?

Chidem said – “The reason banks fail is the same as it has always been since they’ve existed: they make bad loans, often in market conditions that encourage optimism.”

Banks may also fail for other reasons. Most importantly, with regard to the current recession, banks may fail because a shortage of money increases the real burden of debt above what it would have been in monetary equilibrium. In other words, many loans appear,ex post, to have been “excessively risky”, but would have been fine in the absence of the money shortage.

Just as an excess supply of money can make loans seem less risky than they really are, an excess demand for money produces just the opposite illusion. I do not believe the banks were so much at fault, because they rely on the Fed to provide a monetary environment that prevents such distortions.

Actually, there was no deregulation of commercial banking, which was indeed where the crisis originated.

Nor was it just a matter of bankers “making bad loans.” It was a matter of them being encouraged to retain and buy bad loans packaged into mortgage-backed bonds by the main regulation that has always applied to commercial banks, ever since deposit insurance was instituted: capital adequacy regulations.

Under Basel I (1988) capital adequacy regulations, the world’s banks were required to spend only 50% of the capital on a mortgage as on a corporate bond or a commercial loan. Under the Recourse Rule (2001), U.S. banks were required to spend only 40% of the capital required for mortgages on AAA or AA rated bonds consisting of mortgages–20% of the capital required for corporate bonds or commercial loans.

In our forthcoming book from the University of Pennsylvania Press, _Engineering the Perfect Storm,_ Wladimir Kraus and I show that U.S. banks held three times the proportion of these bonds in their portfolios as did other U.S. investors. This is directly attributable to the Recourse Rule, and appears to have been the cause of the financial crisis.

An excellent post by Chidem. If the Fed were a commercial bank, it would be closed.

It is a matter of fact that banking and healthcare are the most regulated industries in the US. And they are both beset with problems.

The regulations from the Great Depression were in effect until 1999. The 1999 “deregulation” recognized what was long since reality: commercial banks and investment banks were doing essentially the same thing.

The 1999 law (Gramm-Bliley-Leach) legalized what was fact. The only concrete thing it accomplished of note was to legalize the merger between Citicorp and Travellers, now essentially unravelled by events.

Isn’t that over-concentrating on the liabilities rather than the full balance sheet?

I mean, Banks often keep higher capital ratios than Basel recommends anyway. And with the accounting lag on writing down losses I was under the impression that higher capital requirements actually do very little to prevent insolvency, unless it’s a dramatic increase..?

And how do you increase capital requirements without creating incentives to take riskier and more rewarding assets?

I’m definitely pre-ordering your book by the way, thanks for the heads up..

Yuan Sun,
I realize it is the fashion these days to blame any and all adverse financial events on deregulation. But the Fed continued to have extensive authority over depository banks. Had it wanted to, it could have restrained their lending. There was no “deregulation” preventing action by the Fed.

And it was not “deregulation” that made the Fed keep interest rates low even as the bubbles formed, thus providing the fuel.

Jerry O’Driscoll,
The bank deregulation issue is something of a red herring, as your explanation clarifies:
“The 1999 law (Gramm-Bliley-Leach) legalized what was fact. The only concrete thing it accomplished of note was to legalize the merger between Citicorp and Travellers”

Lee Kelly,
I don’t object to your point. But the Fed’s role becomes clearer if we think of the whole cycle–easy money in early 2000s, encouraging credit creation, then tightening. This is the boom/bust cycle, and while Fed monetary policy is behind it, the banks themselves willingly fell into the trap in the first stage. But I’m not trying to assign blame, just to understand what happened.

Mathieu–Not sure you can preorder yet; but another book on the crisis from Penn, which I edited, _What Caused the Financial Crisis,_ can be preordered. It’s a republication of a special issue of _Critical Review_ with a long intro by me.

Your point about excess capital reserves (above the legal minimum) is v. important. Apparently the literature is mystified by why banks do this (correct me if I’m wrong–I’m a political scientist). But one thing Wlad and I puzzled over is that in the aggregate, commercial banks did *not* leverage up during the 2000s. In other words, their levels of capital kept up with the huge growth in assets over the decade. So why buy assets (not liabilities) such as mortgages and mortgage bonds that required so little capital, if not to increase leverage?

One answer is that some banks did leverage up (Citi), while others deleveraged (JPM, BofA). But another answer is that by buying assets favored by Basel I and the Recourse Rule, banks were increasing their *usable* capital cushions by reducing the amount of capital that had to be devoted to *regulatory* capital.

Regulatory capital is basically wasted. If you fall below 10% capital your deposit-insurance fee doubles, and if you fall below 8% you are in danger of being seized by the FDIC. So you have to keep 10% capital to avoid these consequences, but that means that the 10% *isn’t* serving the very purpose of capital cushions, which is to protect against unexpected losses–because in a crisis, banks cannot let their capital levels drift below 10%. All that capital therefore has no cushioning effect.

By buying assets that required less capital by law, a bank could redirect capital that otherwise would be wasted on regulatory capital requirements into providing a cushion against the unforeseen. That cushion is the amount of bank capital above the legal minimum.

Unfortunately, the cushion wasn’t big enough to protect against the exaggerated [panic-induced] mark-to-market hits that banks took against their capital during 2007-8, so bank lending contracted dramatically.

To endorse what Chidem said: I cannot emphasize too strongly the extensive powers the Fed and other bank regulators possess. The fact they chose not to use them is best explained by Public Choice theory: regulatory capture. It was a failure of will, not of means.

The NY Fed is notoriously unwilling to reign in the big banks. Richard Fuld, CEO of Lehman, sat on the NY Fed’s board. The NY Fed had a team inside Lehman. The idea they didn’t know what was going on is fantastic.

Nor did the Fed need powers over investment banks. Investment banks fund through commercial banks. The Fed could have restrained or shut down that funding.

Jerry’s analysis should be more widely known. The bank deregulation story has drowned out key facts–the Fed’s extensive powers, regulators’ choice not to use their powers and the role of regulatory capture.

As for Lehman’s CEO Fuld sitting on the NY Fed board, it’s not something that the Fed likes to publicize, of course.

Jeffrey Friedman’s argument suggests that Basel had nasty unintended consequences. It is an intriguing question what Basel III will do. It is still in the works, I think. Rule changes might have yet other unintended consequences.

Bank deregulation, which is a figment of your imagination, did not cause the S&L crisis. It was caused by a toxic combination of regulations, including some aimed specifically at the S&Ls, combined with an historically high interest rate environment. Bert Ely has a good summary in this article:

Allowing banks to attract deposits from out of state was the problem? Not allowing them to do so sounds like a first cousin of unit banking, which caused over 9,000 banks to fail in the Great Depression. That’s a prescription for keeping banks too small, undercapitalized, and not allowing them to have anywhere near an optimum portfolio diversification. Jimmy Stewart is dead–long live Jimmy Stewart!
How did it create the illusion of a “safe but higher return”? To the extent that bank deposts are safe (as in “guaranteed”) that’s caused by the FDIC, which is the opposite of deregulation.

yuan sun,
Re “while the fed did keep rates too low, in the end, governments are dumb and slow while businesses have the incentive to game the system.”
So, the solution is to force businesses to also be dumb and slow? Or should government agents game the system? In fact, they do already.

Banks and financial institutions are either stupid masochistic amateur, or are trapped in a race to the bottom which they cannot outmaneuver.

The latter explanation is far more likely, but what causes this race to the bottom to be so compelling to periodically crash down the whole system?

One explanation is the safety net: banks do not care about doing stupid things because politicians will help them in case of need.

At present I know several papers which claim this: some has found that monetary intervention enhances maturity mismatch and illiquidity, others that it increases financial leverage, still other that it causes mass herding toward excessive risk taking, and finally it has been found that stock markets can double in value with a small “Greenspan put” embedded into them.

It doesn’t make much sense to regulate a system where the regulated are subsidized to circumvent the regulations by monetary and credit policies: regulators and monetary authorities have mutually inconsistent strategies, and the attempts of the former are doomed because of the latter.

Fear is engendered when one thinks of what the future could hold in the hands of those who are charged with “fixing” a damaged economy. Many are beginning to question whether the American dream has ended for millions. http://www.christianretirement.com/newsblog.asp?action=ind&pub_id=19840 The major, top-ten bank where my spouse is employed was basically “forced” to receive TARP money against their wishes or face the consequences.

Pietro M.,
That’s a very nice summary of recent studies. No doubt there is lots of moral hazard in the system, and now more than before because of the massive bailouts.

However, it does not fully explain the “race-to-the-bottom” as you put it. Bear Stearns was bailed out, but what that means is that the bondholders were bailed out. The top management lost their jobs and the stock they held in the company. They could not have taken risks on the expectation of a bail-out that would destroy their careers and wealth. They made mistakes.

It goes back to human nature–the limits of rational calculation, whether by bankers, regulators or monetary policymakers. Alan Greenspan, one of the smartest people around, equipped with a big staff of smart economists and with access to huge amounts of data, made mistakes. So the rest of us are guaranteed to make mistakes.

What role do the compensation practices play? You say executives lost their jobs. But many left with piles of money.

Let me suggest an analogy. Suppose the “punishment” for committing a series of bank robberies was that you were forbidden from robbing banks in the future. But you kept all the loot you had already accumulated. Would you view that as an effective deterrant?

Jerry,
I agree that compensation should be set up to encourage executives to pay maximum attention to the long-term well-being of the business. This is the question of how to structure stock options. They should be long-term. And that appears to be the current trend.

Are there papers regarding the genesis of compensation schemes as optimizing behavior? Something like a model in which the principal/agent institutional relations are endogenous.

I’m sure there are papers showing how short run incentive structures have bad long run consequences. What I cannot explain is not, however, why agents act opportunistically if facing bad incentives (that’s obvious): it’s why principals are so fool. Lemons markets usually disappear, they don’t thrive.